SubscribeRecent headlines have been dominated by a single word: subprime. Over 30 lenders have closed their doors in the past three months, and America's second-largest subprime mortgage provider, New Century Financial, filed for bankruptcy protection on April 2.
This instability has put investors, Congress, and market analysts in a state of panic. What lies behind all the hype? In this Focus, we examine the events occurring in the subprime market and their impact on residential construction.
Understanding Subprime Loans
The subprime mortgage market is fueled by risky loans. Typical subprime customers are new home buyers with low income or credit issues that prevent them from entering into a standard mortgage agreement. Structured much like a typical prime mortgage, a subprime mortgage differs in its reliance on higher rates and fees to compensate for the greater costs associated with this high-risk market segment.
Typical subprime loans are marked by a low teaser rate. The mortgage market entices buyers with adjustable rates and 2/28s. These are loans in which the introductory years consist of small monthly payments that are then adjusted upward to account for the remainder of the loan. The adjusted payments are often much higher than those paid by prime homebuyers, helping to offset the lender's risk against the individual's greater chance of default.
Cause and Effect: The Housing Bubble and Subprime
In 1994, the Federal Reserve estimated the share of subprime loans among mortgage originations at 5%. By 2005, this share had increased to 20%, and many analysts recognize that the spike was driven by events associated with the recent housing boom. During this period, home appreciation rates were at record highs, and the demand for housing was greater than the supply. To capitalize on the explosive market, lenders loosened loan qualification standards and enabled many buyers to purchase homes they previously could not afford, thereby boosting the subprime market's mortgage share.
Overall, the subprime market both contributed to and profited from the housing "bubble." By increasing the number of potential homebuyers, subprime loans artificially enhanced the robust growth rate in the residential construction market, resulting in even higher home appreciation rates and even more demand for subprime loans. However, because this increased demand was financially unstable, the influx of previously unqualified buyers simply inflated the growing housing bubble.
In fact, the popularity of subprime loans and their corresponding demand inflation have helped ease the "pop" many expected in the housing market during 2006. When the market began to slow, subprime lenders loosened their borrowing standards even further, and many loans were made against property or without income documentation. In essence, purchases from high-risk subprime homebuyers injected hot air into the leaking residential construction balloon, preventing a burst from occurring.
Unfortunately, this circuitous backpedaling could not shield lenders from the price of poor investment decisions, nor could it rescue or repair a shrinking bubble. Lenders are now facing the consequences of their risky mortgage strategies and the excessive loans they made during the past several years. As borrowers enter into the years of higher monthly payments, with their 2/28 stipulations coupled with rising interest rates, many have been unable to absorb the additional costs.
The rapid decline in home prices in some areas of the country has also caused turmoil in the industry; for many new homeowners, their mortgages are now actually worth more than the value of their homes. As a result, an increasing number of subprime borrowers are going into delinquency or foreclosure. In the last quarter of 2006, 13.3% of subprime mortgages and 4.95% of U.S. mortgage loans overall were delinquent, according to the Mortgage Bankers Association.
Foreclosures were pegged at 1.19% in the last quarter of 2006, and market analysts expect that number to increase throughout 2007. The rapid growth in defaults has significantly impacted subprime lenders and has forced over 30 businesses, such as New Century Financial, to shut down or file for bankruptcy. Insurance costs for subprime lenders have also skyrocketed, and for all practical purposes, the industry is no longer a major source of funding for new home loans.
This market correction has the media up in arms. Panicked phrases such as "the new dotcom," "market implosion," and "economic recession" are everywhere, and TV analysts are quick to provide gloomy forecasts for industry segments affected by the subprime meltdown. State and federal regulators are proposing stricter guidelines on adjustable subprime loans, and Capitol Hill is being pressured to rewrite Federal Housing Administration (FHA) rules. Without a doubt, these events and their fallout will have a marked influence on the well-being of the economy, especially the residential construction market. How strong will the impact be? How long will it last?
The Impact on Residential Construction
Global Insight's forecasts indicate that the collapse of the subprime industry will weigh heavily on residential construction in 2007. Just as growth in the subprime market increased demand for homebuilders over the past few years, the shakeout is now increasing supply. The U.S. Department of Commerce estimates a record four million unsold homes are available on the market, and increasing delinquency and foreclosure rates will force the industry to absorb even more homes through the remainder of 2007.
In addition, a return to the stricter credit requirements adhered to prior to the 2004 boom will affect the other side of the standard supply-demand equation: the tightening of credit will significantly lower the number of buyers who qualify for home loans. Both of these developments will lengthen the time it takes to sell a house, especially in certain regions of the country, and should result in further declines in home prices and housing starts.
For businesses entrenched in the residential construction segment, the market adjustments could not come at a worse time. New home sales are at their lowest level in almost seven years, and Global Insight measures February housing starts at 1,525,000, down 28.5% from a year earlier. Homebuilders' earnings have also confirmed the downturn. Lennar; KB Home; Hovnanian Enterprises, Inc.; and Toll Brothers, Inc. all released disappointing first-quarter results and lowered longterm guidance. Of these, KB Homes alone posted an 84% drop in fiscal first-quarter earnings, and Chief Executive Jeff Mezger warned that the subprime market may continue to worsen the already-pessimistic housing situation before a correction can occur.
Global Insight's construction service confirms Mezger's assessment. The subprime mortgage market will continue to impede new and existing home sales, which are expected to drop in 2007. Housing starts will fall again during the crucial spring selling season, but will turn around in mid-summer due to falling inventories and increasing household formation. However, residential construction leaders should not resign themselves to the short-term weaknesses of the national market. Opportunities in multi-family housing exist in many parts of the country, but businesses will need to think strategically in order to capitalize on state-level growth. The subprime fallout may have obstructed housing's slow but steady comeback, but lessons learned from the market adjustment will provide a more sustainable future for residential construction as the industry returns to force in mid-2008.
This article was extracted from Global Insight's U.S. Construction -- State and Metro Area Focus. For a free sample of this service, please visit http://www.globalinsight.com/Construction.